Question

 

• Describe a person or nation who has a particular comparative advantage in something.
• What is the source of this comparative advantage?

Be sure that your example shows that you understand the idea of opportunity cost and how opportunity cost is related to comparative advantage.

Here is the lecture on comparative advantage to use as reference:

The purpose of this lecture is to examine how trade can create economic gains. Trade can take place between individuals or between nations. Regardless of the scope, the potential for economic gains will depend on the same criteria. To set the stage, consider the following basic ideas: • Individuals have limited financial resources (budgets or income) for consumption and limited time and energy for production. We can’t have it all and we can’t do it all. • Nations have limited productive resources (land, labor, capital) to produce goods. • This scarcity forces us to make decisions regarding how to use our financial and productive resources. • Efficient use of time and basic human nature (rationality) often compel us to first produce things that have relatively low opportunity cost. This is known as the low-hanging fruit principle. • In addition to choosing what to buy, individuals and nations must choose what to produce. • A general context for this latter choice is the decision regarding whether to be a specialist or a generalist. That is, we have to choose between making a limited number of goods and making them very well (i.e. being “specialists”), or producing a wide variety of goods, but perhaps sacrificing quality (i.e. being “generalists”). Some interesting economic questions to consider regarding specialization: • Which form of production (specializing or generalizing) leads to greater potential for economic gains? 2 • Does causality flow in both directions? That is, does one’s approach to production lead to their economic status, or does one’s economic status lead to their approach to production? This second question is one that I think about a lot. My research requires that I travel quite a bit in the developing world, mostly in the Caribbean. My wife and I lived in the Caribbean for about 7 months in 2007. We quickly learned that our friends and neighbors were generalists. Just about everyone has multiple talents. Someone who is a good cook might also be an excellent spear fisher and auto mechanic. A seamstress can likely give you a great haircut, grow produce and adeptly slaughter a lamb. Of course, by U.S. standards, these people are quite poor, at least financially speaking. Which way does the causality flow? Does being a generalist lead to lower income? Or does low income force you to be a generalist? I think it’s probably both, but it’s interesting to consider how specialization, trade and well-being are related. Before we get to the notion of comparative advantage and trade, let’s first look at a related principle… The law of increasing opportunity cost (a.k.a. The low-hanging fruit principle) Consider being faced with a household task like doing laundry or cleaning up the yard. Given that you have a limited amount of free time available, how should you approach the task? It makes sense to focus your initial energy on components of the task that can be accomplished relatively easily, that is, those with low opportunity cost (the “low-hanging fruit”). By targeting the relatively easily accomplished goals first, we get more out of our limited resources. There are numerous household and business applications of this principle. When faced with multiple problems and limited resources to solve them, it makes sense to tackle the easy-to-solve problems first. Taking this principle forward to a series of tasks (call it a “to do list”), we see that if we address low-opportunity cost tasks first, then opportunity costs will increase as we spend more time addressing the list of tasks. This is why the low-hanging fruit principle is also called the principle of increasing opportunity costs. This principle can be applied at an individual level or a national level. Textbooks typically cover the latter when discussing the “production possibilities” model of national output. We’re not going to get into that model in this class, but you’ll likely come across it when reading your text. The “bowed-out” (concave to the 3 origin) shape of the production possibilities curve reflects the law of increasing opportunity costs. This model suggests that for a nation to continually increase its production of one good (say cars) it will have to sacrifice more and more production of other goods (say chocolate). That is, the opportunity cost of producing a particular good rises as more of that good is produced. This brings us to the notion of trade. I like to start off by thinking about the motivations for trade, both at the national level and the individual level. Why do we trade with other nations? Why do we import Japanese cars and stereos? Why do we import German beer and French wine? Why do we purchase textile products from Central America? Why do we import all of our cell phones? … Can’t we make these products ourselves? Likewise, why do other nations buy our stuff? Why does Japan buy our corn and beef and wheat? Why do other nations buy U.S. aircraft parts, military equipment and health care equipment? … Can’t they do this stuff themselves? Hopefully, you’re thinking about the fact that certain nations are just better at making some goods than other nations. We import products from other nations because other nations can produce those goods better, cheaper or better and cheaper than we can. Just like people are good at doing some things better than others, nations too are inherently good at doing certain things and bad at doing others. It’s important to consider individual production as an analogy here. You don’t produce everything that you consume. You have clothes, a car, a cell phone, a computer; you consume food and hundreds of other things that you do not produce. You acquired these goods through trade. Obviously, we use the medium of money to first trade our labor for currency and then currency for goods and services, but trade between nations is no different than trade between people. 4 We trade because it’s more efficient. That is, via trade we can have more goods and services and a higher quality of life than we can without trade. Think about it… What would your standard of living be like if you could only consume goods that you produced yourself? What would your life be like if you had to grow 100% of your own food and make 100% of your own clothes and shelter? You’d work a lot more than you do now, and you’d have a meager standard of living at best, assuming you could even survive. But, by specializing in producing one thing and doing it really well, and then trading that one thing with others who are doing something else, we can consume a lot more than we could if we did not specialize and trade. The same holds true for nations. Trade makes us better off. Given that we know certain nations can produce certain goods better than others (that is, better quality for same cost or the same quality for lower cost), we need to consider what this means and why it happens. • What is the US good at producing? → Agricultural products (corn, soybeans, oats, barley), high-tech equipment (air craft, military, medical, telecommunications), semiconductors… • Why are we good at producing these things? → The U.S. is endowed with millions of acres of fertile farmlands, a temperate climate and has developed the physical and human capital for excellence in high-tech industrial production. • What does it mean? → It means we can produce these goods at lower (opportunity) cost than other nations can. We can produce these goods cheaper, or better or better & cheaper. 5 Now consider the same ideas on an individual level… What are YOU good at producing? Why are some people better at producing some goods than others? To be efficient, we should specialize in producing the goods we’re good at and trade for the rest. This idea is known as the principle of comparative advantage: if nations (or individuals) specialize in the production of goods and services that they can produce at lower opportunity cost relative to other nations, then there can be mutual gains from trade. i.e. more efficient production and consumption and higher standards of living. These gains from trade allow nations (and individuals) to consume combinations of goods and services that they could not consume without trade. Let’s explore a simple example to illustrate this point. COMPARATIVE ADVANTAGE EXAMPLE Assume that Al and Sal are trapped on a desert island and can only produce two goods: Fish (F) and Coconuts (C). Assume that the following table shows how much of each task they could accomplish in one day if they spent the whole day doing just that task. ______________________________________________ Al Sal ______________________________________________ Fish caught 20 15 Coconuts collected 5 3 ______________________________________________ To be clear, Al can catch 20 fish or collect 5 coconuts in one day, while Sal can catch 15 fish or collect 3 coconuts in one day. Clearly, Al is more talented at catching fish and collecting coconuts. Perhaps he has some natural talents for these activities or maybe he has some prior experience or training. You might be tempted to conclude that because of these talents, he cannot gain from trade with Sal, but you’d be wrong. 6 To get a better idea of what they are each capable of producing (and consuming) without trades, let’s graphically illustrate each person’s individual production possibilities. Recognizing that Al and Sal do not have to spend their entire day doing one activity, they can each produce different combinations of output depending on how they allocate their time during the day. Al’s production possibilities can be illustrated as: Fish/day 20 16 12 8 4 0 1 2 3 4 5 Coconuts/day Sal’s production possibilities can be illustrated as: Fish/day 15 10 5 0 1 2 3 Coconuts/day Combinations of fish and coconuts are represented by the black dots. Depending on how Sal allocates his time during the day, he can produce any of these combinations of fish and coconuts. e.g.  Spending a full day fishing = 15F + 0C  Spending 1/3 of the day collecting coconuts and 2/3 of the day fishing = 10F + 1C  Etc. Combinations of fish and coconuts are represented by the black dots. Depending on how Al allocates his time during the day, he can produce any of these combinations of fish and coconuts. e.g.  Spending a full day fishing = 20F + 0C  Spending 1/5 of the day collecting coconuts and 4/5 of the day fishing = 16F + 1C  Etc. 7 If the principle of comparative advantage is correct, we should be able to show that via trade, each person can consume beyond their own production possibilities. Recognizing that having a comparative advantage in something means having a lower opportunity cost than your trading partner, our next step is to calculate the opportunity cost of each activity for each person. Al’s opportunity costs For Al, the opportunity cost of catching 20 fish is collecting 5 coconuts. That is, if he spends an entire day fishing, he gives up the chance to collect 5 coconuts. Simplifying, we see: ⇒ The opportunity cost of 1 coconut is 4 fish. ⇒ The opportunity cost of 1 fish is ¼ of a coconut. So, by changing his time allocation between the two activities, Al can trade goods at the rate of 1 coconut for 4 fish (which is equivalent to 1 fish for ¼ of a coconut). Note that these opportunity costs are easily seen in the slope of Al’s production possibilities graph. Sal’s opportunity costs For Sal, the opportunity cost of catching 15 fish is collecting 3 coconuts. That is, if he spends an entire day fishing, he gives up the chance to collect 3 coconuts. Simplifying, we see: ⇒ The opportunity cost of 1 coconut is 5 fish. ⇒ The opportunity cost of 1 fish is 1/5 of a coconut. So, by changing his time allocation between the two activities, Sal can trade goods at the rate of 1 coconut for 5 fish (which is equivalent to 1 fish for 1/5 of a coconut). Note that these opportunity costs are easily seen in the slope of Sal’s production possibilities graph. 8 Next, let’s use these opportunity costs to see who has comparative advantage (i.e. lower opportunity cost) for each good, and therefore who should specialize in each good. Al has a lower opportunity cost for coconuts so he has the comparative advantage in producing coconuts (he gives up only 4 fish per coconut while Sal gives up 5). Sal has a lower opportunity cost for catching fish so he has the comparative advantage in producing fish (he gives up only 1/5 of a coconut per fish while Al gives up ¼). We can conclude that Al should specialize in producing coconuts and Sal should specialize in catching fish. In other words, Al should spend all of his time producing coconuts and Sal should spend all of his time catching fish. They can then trade and have a higher standard of living.

Answer 1

In order to understand comarative advantage we need to first understand opportunity cost. Opportunity cost of any good is the amount of other that is given up or sacrificed in order to produce that very good.

We can discuss comparative advantage between two persons Mitch and Joe with a simple example. Suppose Mitch and Joe live in their respective farms farm spend their time weaving cloth and milking their cows. We can show their required time of production in the following table:

Minutes required to produce unit quantity

	Cloth	Milk
Mitch	60 minutes/piece	15 minutes/litre
Joe	20 minutes/piece	10 minutes/litre

Suppose both Mitch and Joe works 8 hours a day and weaves cloth and milk their cows. The above table shows how mutch time Mitch and Joe individualy takes to make 1 piece of cloth and 1 litre of milk. According to the above table, Mitch takes 60 minutes to weave 1 piece of cloth and 15 minute to get one litre milk. While Joe take 20 minutes to make 1 piece of cloth and 10 minutes to get 1 lotre pf milk.

Now if Mitch uses whole 8 hours to weave clothes, he can weave 8 clothes and if he uses whole 8 hours to get milk from cows, he can get 32 litres of milk. On the other hand if Joe uses 8 hours to weave clothes, he can weave 24 clothes and if he uses 8 hours to get milk, he can get 48 litres of milk. This is shown in the table below:

Amount produced in 8 hours:

	Cloth (piece)	Milk (litre)
Mitch	8	32
Joe	24	48

In the above table it can be easily seen that Joe can weave more pieces of clothes as well as more litres of milk by working 8 hours than what Mitch can do. Hence we can say Joe has an absolute advantage in producing both the products.

Now coming to comparative advantage the situation is not same. In order to understand compareative advantage we first need to understand opportunity cost. Opportunity cost of a certain good is the amount of other good(s) one needs to sacrifice in order to produce that good.

Now lets consider Joe's oppotrtunity cost first in the above example. Joe needs to work 20 minutes to weave 1 cloth. And Joe needs to work 10 minutes to get 1 litre milk. Hence in order to produce 1 litre milk, he needs to sacrifice 10/20 = 1//2 clothes. On the contary, in order to produce 1 cloth, Joe needs to sacrifice 20/10 = 2 litres milk.

Similarly, in order to produce 1 litre of milk Mitch needs to sacrifice 15/60 = 1/4 clothes and in order to weave 1 cloth Mitch needs to sacrifice 60/15 = 4 litre milk.

The opportunity cost of Mitch and Joe for both the goods is shown in the table below:

Opportunity cost of

	1 cloth	1 litre milk
Mitch	4 litre milk	1/4 cloth
Joe	2 litre milk	1/2 cloth

Now the person who sacrifices less in terms of other good in order to produce one unit of a good has lower opportunity cost of producing that good and is said to have comparative advantage in producing that good.

Hence from the above analysis we can say that Joe has comparative advantage in weaving cloth as he needs to sacrifice less amount of milk than Mitch. Joe has to sacrifice 2 litres milk whereas Mitch has to sacrifice 4r litres of milk in order to weave one cloth. On the other Mitch has comparative advantage in producing milk as he needs to sacrifice less number of clothes than Joe. Mitch needs to sacrifice 1/4 clothes whereas Joe has to sacrifice 1/2 clothes in order to produce one litre milk.

As opprtunity cost of producing one goods is inverse to the opportunity cost of producing another good for a particular person, One cannot have comparative advantage in producing more than both good in two goods economy. In order to get benifit in trade one should produce the very product on which it has comparative advantage and trade that good with others. In this way trade can be benificial for all.